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SECURITIES AND CORPORATE FINANCE ALERT
JOBS ACT OFFERS NEW CAPITAL RAISING ALTERNATIVES FOR STARTUPS—PART I
On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS” Act), a product of rare bipartisan Congressional action and White House support. The JOBS Act contains several provisions intended to make it easier for small and emerging companies to access capital markets by, among other things, (i) amending existing federal securities statutes and SEC regulations and (ii) preempting certain state laws that otherwise might interfere the JOBS Act’s objectives. This Securities and Corporate Finance Alert summarizes just one of the significant provisions of the JOBS Act, namely, the provision that permits companies to raise capital by offering and selling securities in small increments from several investors, a process known as “crowdfunding.”
General Background—Crowdfunding and Traditional Securities Offerings
Crowdfunding is a relatively recent phenomenon employed by artists, entrepreneurs, and others to raise funds from many people in small amounts from each contributor. Projects such as opening yoga studios, artistic projects (for example, recording projects and video game production projects) have been funded by crowds (for example, friends and family of the entrepreneur, or complete strangers who care about the project), and in theory there is no limit to the types of projects that can be successfully funded by crowds. The contributions do not have to be paid back, as they are not loans, but the entrepreneur may show his or her gratitude for contributions by, for example, giving discount coupons, beta versions of the video game, t-shirts, or samples of the product or service being funded.
Until the passage of the JOBS Act, crowdfunding was prohibited as a means to attract investment capital, i.e., capital in exchange for an ownership stake in the venture. The federal Securities Act of 1933 and similar state securities laws generally prohibit offers and sales of securities without registering those securities, unless the laws provide for an exemption from the registration requirements. Title III of the JOBS Act, the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,” or CROWDFUND Act, provides a new exemption from federal and state registration requirements. The new act can be used by nonreporting companies to sell securities to an unlimited number of investors. Moreover, the investors need not be “accredited investors,” as defined in SEC rules (e.g., venture capital funds, institutional investors, and well-heeled individuals). The CROWDFUND Act contains substantial restrictions, limitations, and conditions intended for investor protection, however, and it cannot be utilized by startups yet—the SEC must first adopt rules and regulations to implement the new statute. This Alert summarizes some of the significant the provisions of the CROWDFUND Act relevant to companies that may seek to raise startup capital and the entities that can assist with the raising of that capital, once the SEC rules are adopted.
Requirements as to Size and Manner of Offering
• The aggregate amount of securities sold by the issuer during any 12-month period by means of this exemption may not exceed $1,000,000.
• The aggregate amount of securities purchased by any investor during any 12-month period, from all issuers in all crowdfunding offerings, may not exceed:
– the greater of (i) $2,000 or (ii) 5% of the investor’s net worth or annual income, as applicable, if either the investor’s net worth or annual income is less than $100,000; and
– 10% of the investor’s net worth or annual income, as applicable (subject to an aggregate maximum purchase of $100,000), if either the investor’s net worth or annual income is equal to or more than $100,000.
• the funding transactions may not be conducted by the startup itself but must be conducted through an intermediary—either a broker or a “funding portal” (see below).
Requirements as to Intermediaries
• Must be registered with the SEC as a broker or a “funding portal,” i.e.,
– a person or entity acting as an intermediary solely in crowdfunding transactions and that:
? does not offer investment advice or recommendations;
? does not solicit purchases, sales, or offers to buy securities displayed or referenced on its website or portal;
? does not compensate any employee or other persons for solicitation or based on the sale of securities displayed or referenced on its portal; and
? does not hold, manage, possess, or handle investor funds or securities
• Must also register with an applicable self-regulatory organization (e.g., FINRA or other SRO)
• Must provide disclosures about risks and other investor education information specified by the SEC
• Must ensure that each investor:
– reviews investor education information
– affirms that the investor understands risk of loss of entire investment and that the investor can bear such loss
– answers questions demonstrating an understanding of level of risk of investing in startups and risk of lack of liquidity of the investment
• Must take measures to reduce risk of fraud, such as obtaining background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by the intermediary
• Must make available to the SEC and to potential investors, not later than 21 days prior to the first sale of securities to any investor, all information required to be provided by the issuer (see “Issuer Requirements,” below)
• Must ensure that investment proceeds are provided to the issuer only after the amount raised is equal to or greater than a target offering amount, and allow all investors to cancel their investment commitments
• Must make efforts to ensure that no investor has exceeded the limits on purchases (from all issuers in crowdfunding offerings) described above
• Must take steps to protect the privacy of information collected from investors
• Must not compensate promoters, finders, or lead generators for providing the intermediary with personal identifying information of any potential investor
• Must prohibit its directors, officers, partners, and similar persons from having any financial interest in an issuer using its services
• Information Requirements. Must file with the SEC, provide to investors, and make available to potential investors:
– name, legal status, physical address, and website address of the issuer
– names of directors and officers (and similar persons), and each person holding more than 20% of the shares of the issuer
– a description of the issuer’s business-law and anticipated business-law plan
– a description of the issuer’s financial condition, including, for offerings that, together with all other crowdfunding offerings of the issuer within the preceding 12-month period, have, in the aggregate, target offering amounts of—
? $100,000 or less—(I) the income tax returns filed by the issuer for the most recently completed year (if any); and (II) financial statements of the issuer, certified by its principal executive officer;
? more than $100,000, but not more than $500,000—financial statements reviewed by a public accountant who is independent of the issuer; and
? more than $500,000 (or such other amount as the SEC may establish)—audited financial statements
– a description of the stated purpose and intended use of proceeds of the offering
– the target offering amount, deadline to reach that amount, and regular updates regarding the progress in meeting the target amount
– (i) price to the public of the securities, or (ii) the method for determining the offering price and an opportunity for the investor to rescind the purchase commitment after final price is determined
– a description of the issuer’s ownership and capital structure, its outstanding securities and securities to be offered, risks of minority ownership, valuation of the securities being offered, and other information
• Must not advertise the terms of the offering (except for notices that direct investors to the funding portal or broker)
• Must not compensate or commit to compensate any person to promote its offerings without taking steps that the SEC may require to ensure disclosure of such compensation
• Must, not less than annually, file with the SEC and provide to investors reports of results of operations and financial statements
Available to Certain U.S. Issuers Only
The crowdfunding exemption is not, by its terms, limited to any form(s) of entity (i.e., corporation, limited liability company, partnership, etc.), but it may not be used by an issuer that:
• is not organized under the laws of a State or territory of the United States or the District of Columbia
• is a reporting company under the Securities Exchange Act of 1934 (i.e., required to file reports on Form 10-K, 10-Q, 8-K, etc.) or
• is an investment company (or would be an investment company but for certain statutory exemptions from the definition of an investment company)
Issuers, brokers, and funding portals are not eligible to offer or participate in crowdfunding offerings if they have been convicted of felonies or misdemeanors in connection with certain securities activities, are subject to certain orders of state financial regulatory authorities, or are “bad actors” under SEC rules.
Restrictions on Resale
Securities purchased under the crowdfunding exemption may not be sold by the purchaser during the one-year period from the date of purchase, except:
• to the issuer
• to an accredited investor
• as part of a registered offering or
• to a family member (“or the equivalent”) of the purchaser, or in connection with the death or divorce of the purchaser
The issuer, its principals, and “any person who offers and sells the security in [the] offering” are subject to liability for making an untrue statement of a material fact or omissions to state a necessary material fact.
Preemption of State Law
Securities issued in a CROWDFUND Act transaction are federally “covered securities,” meaning that state laws, rules, orders, etc. relating to registration or qualification of securities and securities offerings do not apply to securities issued in crowdfund transactions. States may still enforce their antifraud laws and regulations against issuers, brokers, and funding portals. Additionally, each state may enforce its laws and regulations against funding portals having their principal place of business-law in the state, provided that the law or regulation of the state is not in addition to or different from the SEC requirements for registered funding portals.
What Startups Can do Now
The CROWDFUND Act requires the SEC to adopt rules to implement its provisions not later than 270 days after enactment. At a recent conference, an SEC staff member pointed out that the 270-day requirement establishes an aggressive schedule for rulemaking. Accordingly, companies desiring to raise investment capital by crowdfunding and companies desiring to register as funding portals may have to wait until early 2013 to take advantage of all that the CROWDFUND Act has to offer. There are, however, other exemptions from registration that have been utilized, and that can continue to be utilized, by startup (and other) companies to raise capital. Businesses wishing to raise capital now may wish explore one or more of these alternative exemptions for their capital needs. Our finance group can work with your company to explore the various alternatives for funding its growth and operations.
The information contained in this Article is for information purposes only and does not constitute legal advice for any specific situation. For more information about the subject matter of this Article, please feel free to contact Jeffrey A. Bartholomew at Robinson Waters & O’Dorisio at 303.297.2600. The invitation to contact us is not intended as a solicitation in any jurisdiction in which we are not licensed to practice law.